Sunday, September 30, 2012

The recent ISDA challenge to CFTC on commodity limits (discussed here) finally paid off. The nonsense about limits on futures holdings preventing "excessive speculation" that causes outsize swings in commodity prices was struck down in court. Politicians blaming the investment community for problems created by fiscal or monetary policy in the US or abroad never made sense. Grandma's multi-billion dollar state pension fund should not be prohibited from buying a basket of commodities (or investing in a fund that does) to protect against inflation risk. It's just silly.

Academic literature clearly points out that price fluctuations in commodities that had no futures contracts have been just as extreme as those traded on futures exchanges. And funds that take concentrated positions in commodities (such as commodity index funds and ETFs) are not the problem. In fact an OECD paper recently pointed out (see bottom of post) that the participation of index and swap funds in commodity markets may actually reduce volatility - possibly because of added liquidity.

OECD: - An unexpected finding was a negative relationship between index and swap fund positions and market
volatility. That is, there is some evidence that increases in index trader positions are followed by lower
market volatility. This result must be interpreted with considerable caution. The possibility still exists that
trader positions are correlated with some third variable that is actually causing market volatility to decline.
Nonetheless, this finding is contrary to popular notions about the market impact of index funds, but is not
so surprising in light of the traditional problem in commodity futures markets of the lack of sufficient
liquidity to meet hedging needs and to transfer risk.

A US district judge in DC agreed.

FT: - The “position limits” rule was to take effect in two weeks. It would have capped holdings of futures and options for 28 commodities and their derivatives, from crude oil to corn and cocoa, expanding existing limits to contracts for any delivery month.

Robert Wilkins, a US district judge in Washington, said on Friday the CFTC failed to heed instructions from Congress requiring it to determine that its rule was “necessary to diminish, eliminate or prevent” excessive speculation.

While junk bonds were impacted by the recent downward adjustment, investment grade bonds did not respond the same way. Even though investment grade spreads widened, the corresponding decline in treasury yields provided an offset. That kept the overall yield (treasury yield + bond spread) stable - it's a bit of a "self-hedging" product.

Year to date LQD (investment grade ETF) has outperformed HYG (high yield ETF) by about 2% as the two diverged recently.

HYG vs LQD total return (Bloomberg)

With the Fed taking investment grade MBS paper out of the market, the bid for strong credits has risen. But IG corporate bonds are now "priced to perfection".

Companies have flooded the market with new supply during the third quarter.

LCD: - ... the third quarter is on track for at least $215 billion of new supply placed to ravenous demand, more than 43% above issuance volume over the same period last year, according to LCD data that excludes sovereign, supranational, split-rated, and preferred-stock issues.

All this makes corporate bonds increasingly vulnerable to risks in the Eurozone, particularly if spreads widen more than treasury yields decline.

LCD: - After corporate credit spreads trended steadily tighter through a robust slate of new-issue supply over the third quarter, flat progressions for spreads over the last several sessions may be at risk as the high-grade market drifts into the fourth quarter against the backdrop of unrest in Europe, trade data show.

Even as cash bond levels held steady in recent sessions, derivative indications flashed warning signals for spreads. Along with a material rise in the VIX index, the CDX IG 19 index continued 2.5 bps higher this morning in an approach to 105 bps, marking a fifth-straight push higher for the index as U.S. markets opened. [see discussion]

Ryutaro Kono of BNP Paribas recently wrote an excellent piece discussing the bubble that was built in emerging market economies (EMEs) which is in the process of deflating. The thesis is simple: EMEs historical growth is unsustainable and these nations are undergoing a tremendous structural (as opposed to a cyclical) adjustment. The current slowdown (see chart below) is the result of the "stripping away" the post-crisis stimulus.

GDP YoY (source: BNP Paribas)

Monetary easing in the US had a direct impact on monetary policy in emerging markets. It works by weakening the US dollar which puts upward pressure on EMEs' currencies. These nations' central banks try to maintain a peg (implicit or explicit) to the dollar to defend their exports' competitiveness. To do so the central banks must buy dollars and sell ("print") their domestic currency. That ends up boosting foreign reserves and increasing the monetary base, creating an extremely easy domestic monetary policy.

Foreign exchange reserves (source: BNP Paribas)

Such accommodative policy combined with infrastructure and other government spending generated unsustainable growth that is currently being reversed.

BNP Paribas: - The direct cause of the slowdown that began last
spring by three big EMEs— China, Brazil and India
— was the stripping away of the effects of the
massive fiscal stimulus adopted in 2009. For
instance, China’s fiscal stimulus package was
massive at RMB 4 trillion (13% of GDP), and this
made China the global economy’s growth engine
following the Lehman shock. What is more,
monetary conditions were also made extremely
accommodative. Specifically, the aggressive easing
by the Fed (QE1 and QE2) spilled over into the
EMEs via their exchange rates. The mechanism
involved worked like this: Because the Fed’s
aggressive easing resulted in the weakening of the
dollar, EMEs had to undertake dollar-buying
intervention in the FX market to neutralize upward
pressures on the local currency, something that
made domestic monetary conditions extremely
accommodative. Thus, the robust growth by the
EMEs these past three years was inflated by the
aggressive monetary/fiscal policies, and so was
unsustainable.

Of course EMEs' growth prior to to the financial crisis was not sustainable either because it was driven by the credit bubbles in the US and the EU.

BNP Paribas: - Because the EME boomed both before and after the
Lehman shock, the impression has taken root that
the EMEs are the global economy’s driver. But the
robust EME growth prior to the Lehman shock was
also not sustainable. In retrospect, we can see that
that brisk EME expansion was made possible by an export boom that was fueled by the bubble-driven
economies of Europe and America. That China
became the world’s production hub is due not just to
its strong competitiveness but also to the voracious
demand from the US and Europe.

This of course does not bode well for global growth in the coming years.

BNP Paribas: - At long last, the process of
undoing this bubble seems to have started. Now if
my supposition about an EME bubble is correct, the
big three EMEs will continue to slow for a while, and
even if a cyclical recovery kicks in, returning to the
former robust growth rates will be hard. That is why
we cannot expect the global economy to pick up the
pace for the time being

Saturday, September 29, 2012

Financial markets' addiction to central bank stimulus is out of control (see previous post). Below are some financial media headlines from the last few days discussing market moves - in no particular order. The news driving markets now constantly originates from central banks (or related government entities) - with earnings mixed in here and there. Central banks' actions (or inaction) are often the major factors in securities valuation. What is not clear however is if market participants and the public understand that this is not how financial markets have typically operated in the past (even though central bank actions were always a component of valuations) and is not how free markets should operate.

We go from this one day:

Reuters: - U.S. stocks rose modestly on Tuesday on investor confidence that Federal Reserve stimulus would underpin equities and purchases by money managers wanting to touch up portfolios before the quarter's end.

Federal Reserve Bank of Philadelphia President Charles Plosser said the U.S. central bank's new mortgage bond-buying program is unlikely to boost growth, and that the effort could harm the Fed's credibility.
"There are many investors who think the Federal Reserve was the catalyst for this latest move," said Michael Shea, managing partner with Direct Access Partners. "If you have another Fed governor dissenting with what the Fed's doing, you're going to spook some people."

And it just keeps going.

PBoC:

Reuters: - Mining stocks .SXPP rose 1.2 percent after China's central bank injected cash into its money markets and traders speculated it may also take steps to boost the country's weak stock market, to arrest a slowdown in its economic growth.

ECB:

Reuters: - Global investors staged a tentative return to euro zone stocks and bonds this month following the European Central Bank's bond-buying rescue plan and credit easing from the U.S. and Japanese central banks, a Reuters poll showed on Thursday.

BoE:

Reuters: - Traders said talk of new central bank stimulus measures from the likes of China or the Bank of England was preventing equity markets from sliding

BOJ:

WSJ: - European stocks rose and the euro nudged up against the dollar Wednesday, after the Bank of Japan jumped on the stimulus bandwagon by announcing an expansion of its asset-purchase program.

The BOJ said it will increase it asset purchases to 80 trillion yen ($1.01 trillion) from Y70 trillion, just one week after the U.S. Federal Reserve announced another round of quantitative easing.

RBI:

The Hindu: - After surging 250 points in anticipation of a rate cut, the Sensex on Monday closed only 78 points higher - registering 9th straight day of gains - as investors were not excited at RBI just reducing CRR by 0.25 per cent and keeping key interest rates unchanged.

And it's not just about the equity markets:

SF Gate: - The yuan climbed to its strongest level since 1993 on speculation China will step up efforts to arrest a seven-quarter slowdown in the world’s second-largest economy.

Investors are “finally realizing that recently announced liquidity injections from central banks will do nothing to address the structural issues,” said Matthew Sherwood, Sydney- based head of markets research at Perpetual Investments, which manages about $25 billion.

Until the next fix...

TheStreet.com: - The U.S. equity market next week will start the final quarter of 2012 with a heavy schedule of reports highlighting conditions in the U.S. economy, with all leading up to figures that will show if there’s been any improvement in the shaky labor market.

In another blow to savers who have suffered from negative real yields in short-term treasuries since the financial crisis, the long-term real yields have now moved deeper into negative territory. The chart below shows that the 10-year zero coupon treasury yield adjusted for inflation expectations hit another record low (-0.89%).

10y zero coupon treasury - 10y zero coupon inflation swap (Bloomberg)

It is a bit surprising that the mass media is ignoring this development. After all it amounts to a tax on American savers - even those willing to lock their savings in treasuries for many years. And this is taking place at a time when the younger workers in the US are saving much more than they used to. For decades American consumers have been criticized for not saving enough, and now that the trend has been reversed, they are being penalized for doing so.

Update: Investment grade industrial companies' bonds real yield is also at record lows. So even savers who are willing to take some credit risk will be getting almost no interest after inflation is taken into account.

The combination of Intrade spike in Obama's victory odds and the president's comfortable lead in battleground states makes his victory in November a near certainty. Barring a mishap in the upcoming debates, we should see more political status quo in Washington. In fact according to JPMorgan "since 1948, no challenger
that lost ground in the polls in the month after his
convention has ever been elected President."

Source: JPMorgan

As discussed before, this is somewhat positive for the equity markets (see post) - in the short-term. A Washington gridlock means that large corporations who view the federal government as their key customer will keep this revenue stream going. Also this assures that Bernanke stays with the Fed, pumping more liquidity into the markets. The long-term effects however are far less certain.

In another sign of developing troubles in the Eurozone "core" states, the Dutch housing market declines (discussed here) are continuing. This is driven in part by weak consumer confidence and uncertainty surrounding the proposed mortgage relief program. According to CS, home sales and residential construction are at new lows.

Dutch housing prices YoY (Source: CS)

If the unemployment rate, which is currently at 6.5% (low by Eurozone standards but fairly high for the Netherlands) rises, bankruptcies will ensue.

WSJ: ... the Dutch have scant reason to be placid. Unemployment is low but rising, and the country only barely tipped out of recession earlier this year. Dutch households are among the most indebted in Europe, which means that higher unemployment could spark bankruptcies. Property prices have fallen to levels not seen for nearly a decade, further straining consumption and increasing the risk of a mortgage-debt conflagration.

The US repo rates have risen to a 3-year high this week. The chart below shows the so-called General Collateral (GC) treasury repo rate. GC simply means that the borrower under the repo loan can post any treasury securities as collateral - as opposed to specific bonds.

Source: JPMorgan

JPMorgan attributes this increase to several factors.

1. Banks' total reserve balances at the Fed has declined recently.

Bank reserves (source: FRB)

Empirically it can be shown that declines in reserves corresponds to rising repo rates. Reserves will begin rising again as the Fed commences balance sheet expansion.

Source: JPMorgan

2. Dealer holdings of treasuries (which are not prohibited under the Volcker Rule) have risen recently, increasing demand for treasury financing.

3. US money market funds, tired of extraordinarily low rates in secured lending (repo), have rolled some of their assets into unsecured US bank paper (commercial paper and CDs). This reduction in repo lending contributed to rising rates. Note that US money funds still prefer secured lending in Europe (discussed here).

Friday, September 28, 2012

After the Ferbruary post on the flaws of Basel III regulation (see discussion) we got a number of emails pointing to the importance of uniform global banking rules. "By criticizing Basel III you support these banksters" was one of the comments. Of course the wrongs of banking could be set right by new rules - even if they are a messy modification of an earlier set of regulations that got large banks (like Citi) into trouble to begin with (see discussion from 2009).

But many professionals in the financial services industry continue to support Basel III, in part because it benefits them. Most people don't fully appreciate how much business the major international accounting/consulting firms for example get from engagements to implement new capital rules at banks. That's why it's no surprise that many advocates of (and experts on) this "enhanced" regulation just happen to be consultants from the Big 4 and other large accounting firms. Nothing wrong with consulting, but there is a bit of a conflict here.

Clearly some of the new rules are important - particularly those dealing with adequate liquidity. But the prescriptive methods used to solve every possible concern dealing with capital and liquidity will push financial organizations to focus on the "letter of the law" instead of the "spirit of the law". And loopholes will inevitably arise (as they did with Basel I) creating more systemic risks.

Some of the problems with Basel III are laid out in this excerpt from a well written article on Bloomberg Brief. The implementation issues emerging from the new regulatory framework are troubling indeed.

Two years later, though, and each
of these axiomatic standards remains
unimplemented in almost every major
banking center. Some have suggested
that, with just a bit more gumption, the
Basel rules will jump national borders to
conquer risk. But, like it or not – and I
don’t much like it – Basel can’t work.
...
The global capital and liquidity standards
codified as Basel III have important
weaknesses of their own – most
important among them undue complexity
resulting from a hopeless effort to
address every nuance in each major
banking market under each applicable
accounting scheme in all circumstances.
But, even if Basel were better, it couldn’t
be consistently implemented in comparable
fashion across borders no matter
how well meaning the national regulator.

The reasons for this are statutory and
structural. First, many nations – the U.S.
is a prime case – have laws that override
key tenets of Basel III. For example,
the U.S. bans reliance on credit ratings,
which means that its risk judgments are
substantively different from those that
underpin Basel III. The European Union
is considering a law that side-steps
implementation of the Basel leverage
ratio – a critical reform meant to prevent
all the risk-weighting games still shockingly
evident across the globe. And,
even where law permits imposition of
Basel’s key provisions, it often doesn’t
let supervisors actually enforce tough
capital rules – mooting the point.

And, even if there weren’t these
statutory barriers to Basel III, profound
structural ones bar comparable crossborder
capital and liquidity standards.
One of the most important here is the
U.S. commitment to community banks,
for which Basel is in many ways inappropriate.
Even if one carved out community
banks, the U.S. still has 34 bank
holding companies with assets over $50
billion, a sharply different and more diverse
banking system than found almost
everywhere else.

Even more significant, the U.S. now
has a combination package of statutory
and structural barriers to Basel III. The
Dodd-Frank Act created an “orderly liquidation
authority” (OLA), a new law that
will end too big to fail by barring taxpayer
support for large banks. In sharp
contrast, the European Union and many
other nations have banks that are not
only backed by too big to fail, but also
“too big to save” expectations by virtue
of national reliance on only a very few,
very large banks.

There are numerous risks to the US economy ranging from China's potential hard landing and the Eurozone crisis to the so-called Fiscal Cliff. However it is the exogenous factors that are often the most damaging. As discussed earlier (see post), a large spike in gasoline prices could do a great deal of damage. Unlike many emerging markets nations, Americans can in fact afford higher gas prices (as painful as it is for the consumer), but the psychology of having to shell out 30-50% more than they paid just a few months ago will clearly inhibit spending across the board. Gasoline price is one economic indicator that most Americans track daily. And the shock to gasoline futures today will do a great deal of damage if it propagates to the gas pump.

The explanation for the spike this time is that someone was covering a large short position. It's almost as good an explanation as the hurricane Isaac causing prices to climb long after the hurricane was gone (see discussion).

Reformulated gasoline for October delivery rose 19.8 cents to settle at $3.3420 a gallon, as the front-month contract came to an end on the New York Mercantile Exchange. By contrast, the next contract, November, finished the session at only $2.9167 a gallon.

Traders and analysts said the jump in the October contract likely was caused by investors who had bet the contract's prices would be lower, known as being caught short, and had to rush to buy futures to cover those positions.

Gasoline active futures contract (Bloomberg)

If prices at the pump continue to climb, US consumer spending (70% of the US economy) could be in real trouble. As it is, high prices in August already put a damper on spending. October could be far worse.

Reuters: - U.S. households stretched to pay for costlier gasoline on meager income growth in August, undercutting spending on other items and pointing to lackluster economic growth.

Thursday, September 27, 2012

The Bank of England recently implemented a new incentive program for banks called Funding for Lending Scheme (FLS) to encourage more lending to households and businesses The idea is to give British lenders access to cheap financing for four years in return for expanding credit.

The financing is in the form of a four-year collateral swap. Banks deliver illiquid loans (pools of mortgages and small business loans) to BoE in return for UK Treasury bills. The bills are then used as collateral for cheap repo loans.

Bank of England: - Over the eighteen months to the end of January 2014 – the ‘drawdown period’ – the Bank of England will
lend UK Treasury Bills to banks and building societies (hereafter ‘banks’). These will be lent for up to four
years, for a fee. As security against that lending, banks will provide collateral – in the form of loans to
businesses and households and other assets – to the Bank of England.

This type of transaction is known as a ‘collateral swap’. When the loans from the Bank of England mature
after up to four years, the collateral will be swapped back again. This arrangement ensures that the risk from
the loans remains the responsibility of the originating bank.

Banks can use the Treasury Bills they access in the Scheme to borrow money at rates close to the expected
path of Bank Rate. Taking that rate together with the fee paid to the Bank of England gives the cost of
funding for a bank using the Scheme.

To encourage banks to lend more, the amount of this cheap financing increases if banks expand lending and declines if lending shrinks. Once again, it's a good scheme in theory, but may play out quite differently in practice.

Many banks have issued longer term debt that is coming due shortly (unsecured bonds). As this relatively expensive debt matures, they will simply roll it into FLS to reduce interest expense. There is nothing in the program that requires that new loans are exchanged for bills - existing loans on banks' books will do just fine. Banks will simply deliver their illiquid loan portfolios and use FLS to refinance their maturing debt.

Daiwa Capital Markets: - Ultimately, we expect U.K. banks to opportunistically
use the FLS as a cheaper
substitute for funding from bond issuance
in the wholesale capital markets and, principally,
to refinance existing bonds when
they mature, as opposed to increasing
lending to the economy.

The chart below shows how much FLS some of the largest lenders qualify for as well as lenders' debt maturing through 2014. Except for Nationwide, the bigger banks will have enough FLS capacity to repay a great deal or all of their maturing bonds.

There is nothing in the program that requires UK banks to lend more and there is nothing to indicate that they will. Instead FLS is becoming a free gift by the Bank of England to the UK's banking system. FLS will be used to reduce interest expense and boost banks' profits. Of course given that the UK government owns large chunks of some of the lenders (Lloyds and RBS), maybe the UK taxpayer will benefit from the program after all.

The European Commission (European Securities and Markets Authority) continues to press their heavy handed CDS regulations in spite of the objections by the UK and Germany. These two states are particularly annoyed at the EC rules that require a CDS protection buyer to be able to prove that they are engaged in hedging a specific asset (or assets) - prohibiting the so-called "naked CDS". That means one can not buy protection on France for example as a general hedge against a downturn in European sovereign finances or the economy as a whole (see discussion). This is the equivalent of prohibiting investors from buying put options without owning the equivalent number of shares in the underlying stock.

UK/Germany: - We regret especially that the hedging requirements concerning CDS are very narrow and inflexible. This could e.g. hinder investments in member states with illiquid CDS markets significantly and hedging against general economic risks.

So let's take a look at the reasons the EC is so scared of CDS. The explanation we keep hearing is that buying CDS protection can be used to "attack" a sovereign debt market. The evil speculators will use CDS to bring down nations by artificially raising sovereign yields. That is absolute and utter nonsense. All the EC has to do is take a look at the data. The chart below compares gross and net Spanish sovereign CDS notionals with Spanish government debt outstanding.

Source: Fitch

First a few words about the gross CDS number. The gross represents nothing more than the trading volume (with a lag). Here is an example:

ABC Fund now has zero net Spain CDS exposure and 20MM gross Spain CDS exposure. The more ABC Fund trades, the larger the gross will be because the fund is required to get the best pricing for its investors by using multiple counterparties. That is why as Spain got deeper into trouble and trading volumes increased, the gross grew. In spite of that increase, the gross number is still a fraction of Spain's total debt outstanding. Moreover with the clearinghouse coming online, ABC Fund will be able to net all three positions and the gross notional will collapse.

But in order to influence sovereign bond yields, one needs to put on large net positions - gross notional has no impact on spread/yield. And net CDS positions are barely visible on the chart above (in red circle). A similar relationship between debt outstanding and net CDS notional can be found for Italy (chart below). Claiming that such tiny exposures can somehow threaten the sovereign bond markets is absurd.

Source: Fitch

What is really happening however is that the CDS markets often act as a "canary in a coal mine", pointing to a specific credit weakness. CDS spreads provide transparency, particularly when transparency is not readily available from other less liquid markets. And many EU politicians and bureaucrats hate transparency because it puts their governments' poor practices on display. So they blame the CDS markets for "attacking" their nation. Everything was fine with Greece until those evil CDS speculators showed up.

A massive monthly decline in US durable goods orders in August once again demonstrated the vulnerability of the US manufacturing sector. The 13% MoM drop is only rivaled by declines during the 08-09 crisis. Granted, a large portion of this was driven by aircraft orders, but it is worrying nevertheless.

US Durable Goods New Orders Industries MoM SA

This release, combined with other poor economic numbers from today have sent the Citi Economic Surprise Index sharply lower.

Citi Economic Surprise Index

Here is a good recap of today's data. One surprise came from lower than expected GDP, which was in part caused by the North American drought.

— Companies cut orders for long-lasting goods by 13.2 percent in August, the Commerce Department said. That was the biggest drop in more than three years but it was largely influenced by a 102 percent decline in volatile aircraft orders. Excluding transportation equipment, orders fell only 1.6 percent. And in a positive sign, orders in a category that reflect business investment plans rose 1.1 percent, the first increase since May.

— The overall economy grew at a 1.3 percent annual rate in the April-June quarter, much lower than the 1.7 percent the government previously estimated. About half of the downward revision stemmed from the severe drought in the Midwest, which cut overall farm output. But growth also fell because exports and consumer spending expanded at a slower pace.

— The number of Americans who signed contracts to buy previously occupied homes fell in August from a two-year high in July. The National Association of Realtors said its index of sales agreements declined 2.6 percent to 99.2. That's just below the reading of 100 that is considered healthy. Still, the index is 10.7 percent higher than a year ago.

... Weekly applications for unemployment benefits plunged 26,000 to a seasonally adjusted 359,000, the lowest level in two months, the Labor Department said. The four-week average, a less volatile measure, fell to 374,000.

Solyndra, the bankrupt US government funded solar sheet manufacturer has put its main factory on the auction block.

LCD: - Bankrupt solar-panel maker Solyndra will hold an auction for its largest remaining asset, the company’s recently completed 412,000-square-foot manufacturing and office facility in Fremont, Calif., with an opening offer of nearly $90.3 million from Seagate Technology.

Solyndra factory (source: GigaOM)

The company has been trying to find a "turn-key" buyer who would come in and restart the operations. However as the prices of solar modules are expected to continue declining, while cost of production at the Solyndra plant would stay fairly constant, no buyers showed up.

Based on the UK solar panel industry, Source: Ernst & Young

The business was marketed internationally - including China, but as discussed a while back (see post) the solar panel businesses in China are also heavily government subsidized (which means a standalone business in the US would not make sense for a Chinese firm).

LCD: - Solyndra originally sought a turn-key sale of its assets last October, but by February the company acknowledged that it had failed to find a buyer. It then initiated a piecemeal sale of its assets, hiring Jones Lang LaSalle Brokerage to market its real estate.

Seagate, the current bidder, would retrofit the facilities to manufacture their own product (hard drives, etc.) - so it's purely a real estate play for them.

Bloomberg: - Solyndra has been liquidating its assets since February after failing to negotiate a deal with a buyer willing to restart operations, according to court papers. So far it has generated about $14.1 million from sales of assets such as solar-panel tubes, manufacturing equipment, appliances and memorabilia and apparel emblazoned with its logo.

With roughly $870 million in debt and the total liquidation proceeds expected to be under $125 million (according to Imperial Capital), the recovery for the debt holders, including the US government, will be quite low.

Looks like Bloomberg reporters just figured out there is a transmission problem from the ultra low MBS yields to mortgage rates (discussed here).

Bloomberg (Sep 26th): - Since the Fed’s Sept. 13 announcement that it would buy $40 billion more securities per month, the rates offered for new 30- year loans have fallen by just 0.13 percentage point, compared with a drop of about 0.7 percentage point for yields on the bonds into which the loans get packaged, according to data compiled by Bloomberg and Bankrate.com. The gap between the two, which typically signals increasing lender revenue when it widens, has reached a record of more than 1.7 percentage point.

The national average 30y mortgage rate has dropped to 3.38%, a new record low. The on-the-run FNMA 30y MBS yield however is not only much lower, but has declined faster (in part due to a sharp decrease in implied duration).

Banks continue to be overwhelmed by mortgage applications, and therefore not in a great hurry to improve pricing - although declines in mortgage rates are picking up (hopefully due to increased competition).

Bloomberg: - Fed Chairman Ben S. Bernanke’s stated goal of helping boost the housing market is being undercut by lenders’ inability to keep up with consumer demand, even as investors drive up bond prices. Banks have been slow to lower rates after being overwhelmed this year by applications to refinance mortgages.

“Think about it this way: If you had a restaurant with 100 people out the door waiting in line, would lowering prices be the first thing on your mind?” said Scott Simon, the mortgage head at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s largest bond fund.

And as discussed earlier, this differential is adding to the banking sector's bottom line. That is partially why banks on average have outperformed the S&P500 by 11% this year.

Bloomberg: - Margins on sales of mortgages have widened by about 50 percent since the Fed’s announcement from the average level this year, which already was elevated, said Kevin Barker, an analyst at Washington-based Compass Point Research & Trading LLC.

“It’s very good to be a mortgage originator right now,” he said in a telephone interview.

Wednesday, September 26, 2012

Here is a good summary of key tax rates across the Eurozone as well as recent changes. As always it's a delicate balance between revenue and growth. In Spain (and Italy to some extent) tax increases have materially dampened economic activity.

Source: GS

Below are Goldman's observations on taxation in the Eurozone:

GS: Many countries implementing fiscal adjustment have increased their VAT rate. ... the three programme countries - Greece, Portugal, and Ireland - have the highest current VAT rate, at 23%. Italy raised its standard VAT by 1ppt to 21%, with another increase planned for next year. Spain also increased both its standard and reduced rates this month. This contrasts with France, which has not changed its VAT rate. Indeed, the newly elected parliament voted against a planned hike in VAT initiated by the previous government. The measure was intended to allow a reduction in French employers' contributions to the social security system. But the new government judged the measure ‘unfair’ for the French consumer. Finance minister Moscovici has moved away from any increase in VAT or CSG social taxes to cut the budget deficit, although they cannot be ruled out, in our view.

... Corporate tax rates have shown more stability. Since 2009, the corporate tax rate has changed in just two countries: Portugal has gradually raised it from 26.5% to 31.5%, while Greece has lowered its rate from 25% to 20%. Ireland in particular has a much lower rate than in the other countries.

The latest Foxconn incident (see video below) is raising more questions about China's manufacturing sector's ability to grow. It is becoming difficult to see how China's overall economy can expand at projected rates with such uncertainties around manufacturing.

WSJ: - The riot raises questions about the sustainability of China's vaunted manufacturing machine. And it poses a challenge to the government that is struggling to satisfy the soaring expectations of a new generation of Chinese workers who came of age in an era of double-digit economic growth and are less willing than their parents to make personal sacrifices for their country...

We are now seeing clear signs of strain faced by China's high tech factories as they attempt to squeeze more production out of their thin margins (discussed here) - and hitting bottlenecks in the process

FT: - [Foxconn] is the sole assembler for the iPhone 5 this year, with 80-85 per cent of shipments next year as well, according to analysts at Barclays. At an estimated $8 a phone, that workload brings in revenue, but has also put the company under strain. To handle Apple’s demands, Citi analysts estimate, Hon Hai must increase headcount at its Zhengzhou iPhone factory from 150,000 workers in June to 250,000 in October.

The relentless selloff in China's domestic stock market is reflecting this uncertainty in manufacturing growth (as well as the renewed volatility in Europe). The Shanghai Composite Index hit a new multi-year low this morning.

The Shanghai Stock Exchange Composite Index (Bloomberg)

China's official news has little on the incident in Taiyuan, but the authorities are clearly preparing the population for weaker growth ahead. As discussed about a year ago (see post), the impending slowdown will increase risks of social unrest and possibly additional production disruptions. That in turn will hurt confidence and investment, as the economy will become increasingly dependent on government stimulus.

China Daily: - China's economic growth is likely to slow for its ninth consecutive quarter in the period from July to September, top policy advisers said on Tuesday.

If their predictions prove true, the government may find itself taking "remarkable measures" to combat the slump, they said.

Zheng Xinli, deputy head of the China Center for International Economic Exchanges, a government think tank, said China’s economic data for August has turned out worse than expected and the economy’s prospects remain gloomy. Amid those circumstances,the country’s GDP is unlikely to grow at a faster pace in the fourth quarter.

"The urgent need right now is to clarify what are the most effective ways to boost domestic demand," Zheng said.

Back in April, we discussed a very simple US housing market index developed by Goldman. The index basically looks at the percentage of US zipcodes that have experienced housing price appreciation (see discussion). Here is an update. Currently roughly 50% of zipcodes in the US are reporting price appreciation - which is still below the lows of the 1982 and the 1992 recessions. However as a comparison, the index was at 20% at the end of Q1. Note that the temporary spike in 2010 has to do with
First-Time Homebuyer Credit program.

Source: GS

As expected, housing price appreciation is held back by distressed sales. The bifurcation of the distressed and the non-distressed markets (discussed here) is slowing the overall market improvement. Those areas with the largest declines in distressed sales saw the largest increases in prices.

Source: GS

This tells us that as we work through the distressed home inventory - which is happening fairly quickly (see discussion), prices should stabilize further.

GS: - ... distressed transactions, including bank real estate owned (REO) sales and short sales, play an important role in the current housing market. In earlier research, we estimated that the declining fraction of distressed sales during the recovery process has contributed materially to recent national house price movements. ... we confirm this finding using regional data. Among the Case-Shiller 20 cities, areas that had severe housing downturns but saw significant declines in the number of distressed sales over the past year -- Detroit, Las Vegas, and Phoenix -- also experienced higher price appreciation this year. Once the housing market fully recovers and the fraction of distressed sales returns to historical normal levels, the impact of the distressed/non-distressed mix on house price growth rate will dissipate. In the near-term, however, we still face a large distressed sales pipeline. This, coupled with investors bidding up REO properties in REO-to-rental programs and banks increasingly resorting to short sales (which has a smaller price discount) rather than REO sales to dispose distressed properties, suggests that house prices will continue to increase even with little improvement in the fundamental economic underpinnings.
...
... the recent strength observed in the housing market could also be related to "pent-up" demand coming back to the market. From 2007 to 2011, falling home prices and subsequent deterioration in the economic outlook may have caused many potential homebuyers to wait on the sideline.
[see this discussion on house price appreciation no longer strongly tied to the economy]

And once again, this has little to do with QE3 and low mortgage rates - the market is driven by completely different dynamics.

IG CDX spread has widened sharply in the last couple of days as the corporate CDS index has become the choice to hedge against global macro risks. It is liquid and provides portfolio managers with a cheap option.

IG CDX (Bloomberg)

And of course the latest macro risks are percolating in the Eurozone once more. Analysts are looking at Spanish debt as a measure of rising risk premia in the Eurozone, but it is the wrong indicator. In spite of Spain's yields rising this morning, they no longer represent the actual stress in the area, given the ECB's potential ability to "manipulate" them. IG CDX and other liquid credit indices are far more indicative.

Spain is again at the epicenter of the renewed volatility. Rajoy is desperately trying to "front-load" the austerity measures in Spain so that they look "internally imposed" rather than a result of the bailout by the ECB - which is coming. But time is running out as tensions in Spain escalate. The anti-austerity protests in Spain - some have been bloody - are making headlines. Of course when over half the nation's young people are out of work, that's to be expected.

A much larger issue rattling the markets has to do with Spain's regions (as discussed back in March). BBC has a good overview of each of the regions and the problems they face (here). The central government is in the process of bailing them out via a fund set up recently (see discussion). Andalucia is now considering asking for a €4.9bn from the Spanish central government, making it the fourth region to be bailed out after Catalonia, Valencia and Murcia.

What really spooked the markets however is the talk of Catalonia's push for independence. The region's government is broke and has asked for a €5bn bailout. Given its wealth relative to other regions however, people there feel they are carrying a disproportionate burden in taxes. And just as the tensions in the Eurozone often revolve around the disparity between the wealthy and the poor states, the same dynamics are at work among the regions in Spain (a bit like northern vs. southern Italy).

Reuters: - The government's drive to rein in regional overspending as part of its austerity measures has prompted a flare-up in independence fervour in Catalonia, the wealthy northeastern region that generates one-fifth of Spain's economic output.

Just as the euro zone crisis has strained relations between wealthier nations of the north and heavily indebted countries to the south, Spain's crisis has aggravated tensions between the central government and its self-governing regions.

Catalonia is broke and needs a 5 billion euros bailout from the central state to meet debt payments this year, but Catalans are convinced they bear an unfairly large share of the country's tax burden.

More than half say they want independence from Spain, the highest level ever.

What market participants are beginning to realize is that Catalonia's independence could push Spain out of the Eurozone - no matter what the ECB does. The region's economy is critical to Spain and the Spanish government desperately needs the tax revenue from Catalonia. The government's budget target for 2012 looks untenable as is. Without Catalonia, the Spanish economy and Spanish government finances would simply collapse.

Tuesday, September 25, 2012

The ECB's massive balance sheet expansion during the past year succeeded in generating growth in the euro area's broad money supply.

ECB balance sheet (€mm)

However the increase in money supply is yet to translate into material growth in credit. The two indicators have diverged.

Source: GS

Part of the problem of course is the issue of "monetary transmission" (discussed here). Liquidity and therefore credit growth is not getting to where it's needed most. The chart below shows growth in loan balances to non-financial corporations (NFCs - lending by banks to companies.) As expected the trends by country diverge dramatically. Increasing money supply simply saturates "core" banks with deposits - to the point where lending is no longer limited by available liquidity. But due in part to capital flight (see post), liquidity is not making its way to the "periphery" banks, limiting credit expansion. The periphery banks therefore hold back credit growth in the Eurozone.

Source: GS

It remains to be seen if the ECB's recent strategy of buying short-term periphery government debt has a material impact on liquidity in the periphery nations and therefore lending in the Eurozone as a whole.

In a sharp correction during the past couple of days the HY bond market erased most of the post-QE3 announcement gains. As discussed before (see post), it was clear that the HY marked was frothy going into the Fed meeting, and now asset allocators are starting to come to grips with the fact that it's gotten even richer. HY CDX and HY ETFs (HYG, JNK) sold off sharply (HY CDX is down 2% in the past 2 days).

The realization is setting in that the Fed bringing mortgage rates to new lows (national average is now at an all-time low of 3.46%) is going to do little to improve the US economy (see discussion) and corporate profits. And some of the Fed members agree with this assessment.

MarketWatch: - “We are unlikely to see much benefit to growth or employment from further asset purchases,” said Charles Plosser, the president of the Philadelphia Fed Bank, in a speech to financial market trade groups in Philadelphia.

The reversal in the credit markets is also visible in the investment grade space. IG CDX has reversed most of the QE3-driven tightening.

IG CDX spread (Bloomberg)

No matter how much MBS the Fed buys, monetary expansion is unlikely to help Caterpillar for example. And markets are starting to get the point.

NASDAQ: - Caterpillar Inc. (CAT ), the world's largest manufacturer of construction and mining equipment, recently joined the bandwagon of companies who have trimmed their revenue and earnings expectations in the wake of weaker-than-expected growth in the global economy. This news led to a 2.4% fall in Caterpillar share prices to $88.73 in after-hours trading.

The Dodd–Frank financial reform is killing the single name corporate CDS market. Liquidity in this market is drying up quickly. This is due mostly to dealers' inability to take positions when they make markets (Volcker Rule) and a cumbersome clearing process that will impose higher margin on corporate CDS for end-users (in some cases higher than the equivalent positions in corporate bonds via repo). In fact the business of basis trades - bonds vs. CDS - is no longer viable in many cases because of the margin requirements on both sides and no ability to offset.

The fact that dealers who clear CDS are not expecting this business to be profitable (see discussion) is not helping either. And single name CDS regulated by the SEC while indices such as CDX regulated by the CFTC adds to the uncertainty. At the same time margin and clearing rules differ materially among the clearinghouses (ICE, CME) and trades are not fungible between them (a trade cleared on the CME can not be offset with the opposite trade cleared via ICE). This uncertainty is adding to this decline in liquidity. The situation is so bad that an index of 100 CDS doesn't have enough liquid CDS for the index to be formed.

FT: - Indices that track the price of credit default swaps (CDS), contracts which act as insurance against a default on corporate bond payments, have become a popular way for banks and hedge funds to speculate on the creditworthiness of American companies and for bond fund managers to hedge risks in their portfolio.

But underlying CDS trading has shrivelled to such an extent that there are not enough actively traded names to make up a 100-company index.

This takes us back to the question of making the financial markets "safer". Not a single institution has ever failed due to a problem with corporate single name CDS. But banks and corporations do use this product to hedge all sorts of things - including receivables, counterparty exposure, reducing loan exposure to a single company, etc. It's not at all clear therefore how nearly eliminating this market through blunt regulation will be helpful for the financial system or the economy as a whole.

Monday, September 24, 2012

The UK households are still pessimistic about their financial situation. But they are less pessimistic than they have been in the last 2.5 years according to Markit UK Household Finance Index (HFI). This is a positive development, given the UK's dreadfully slow economic recovery.

Source: MarkIt

But there is one negative development coming out of this survey however. It seems that in September the UK households became concerned about inflation.

MarkIt: - The main negative development in September was a sharp increase in inflation perceptions, with the month-on-month acceleration the greatest since January 2011 (which followed a VAT rise). There was also a jump in inflation expectations, which reached their highest for four months.

Inflation expectations? That's just silly. The BoE, the ECB, the BoJ, and now the Fed, all expanding their balance sheets in an unrestrained fashion shouldn't make the UK households concerned. And those pesky high food prices are only temporary. The central banks will rein in inflation just as soon as it becomes a problem. Keep calm and carry on ...

As consumers await to receive the shiny new iPhones they recently ordered, attention shifts to Apple's Taiwan-based primary supplier, Foxconn Technology Co. Ltd (otherwise known as Hon Hai Precision Industry Co). Can the company deliver on time? Or would the next factory closure disrupt production? After all, Apple's customers, particularly Americans don't like to wait.

Foxconn employs some million workers in China to meet this demand for Apple's as well as Amazon's, Nintendo's, and Mocrosoft's products (iPad, iPhone, iPod, Kindle, PlayStation 3, and Xbox 360.) With its massive manufacturing capabilities and Apple as a major client, one would think that Foxconn's shares should have benefited at least somewhat from AAPL's parabolic growth. But they haven't.

Bloomberg

In fact Foxconn's shares even lag the Taipei stock index (TWSE) over the past five years in spite of these huge orders from Apple. It seems that the bulk of product margin goes to Foxconn's large clients. Working with thin margins makes Foxconn vulnerable - as the share price clearly shows. Foxconn's story is littered with complaints of poor working conditions and worker abuses (even suicides) as well as riots and factory shutdowns. Foxconn has invested heavily to improve conditions for workers - which hit its bottom line. But recently a reporter from the Shanghai Evening Post infiltrated a Foxconn factory and detailed his experience as an assembly line worker. A "rough" English translation of his story is available here.

Shanghai Evening Post: - By my own calculations, I have to mark five iPhone plates every minute, at least. For every 10 hours, I have to accomplish 3,000 iPhone 5 back plates. There are total 4 production lines in charge of this process, 12 workers in every line. Each line can produce 36,000 iPhone 5 back plates in half a day, this is scary … I finally stopped working at 7 a.m. We were asked to gather again after work. The supervisor shout out loud in front of us: “Who wants to rest early at 5 a.m !? We are all here to earn money ! Let’s work harder !” I was thinking who on earth wants to work two extra hours overtime for only mere 27 yuan (USD$4) !?
...
An iPhone 5 back-plate run through in front of me almost every 3 seconds. I have to pickup the back-plate and marked 4 position points using the oil-based paint pen and put it back on the running belt swiftly within 3 seconds with no errors. After such repeat action for several hours, I have terrible neckache and muscle pain on my arm. A new worker who sat opposite of me gone exhausted and laid down for a short while. The supervisor has noticed him and punished him by asking him to stand at one corner for 10 minutes like the old school days. We worked non-stop from midnight to the next morning 6 a.m but were still asked to keep on working as the production line is based on running belt and no one is allowed to stop. I’m so starving and fully exhausted.

This story is fairly representative of China's high tech (and other) factories. In spite of the seemingly cheap labor, the days of easy money in China's tech manufacturing are over - it's all about scraping by on lower margins. Foxconn has underperformed analysts' expectations in 4 out of 5 past quarters. With high expectations for the second half of 2012, the pressure is on.

Bloomberg

But there is only so much more that can be squeezed out of these production facilities and the workers employed there. Given that margins are already tight, what happens when workers - at least in some areas - successfully press for significantly better pay (particularly as food prices in China rise)? Over the past year salaries of workers at privately-owned businesses in China's urban regions grew 12.3% (adjusted for inflation!). At the same time iPhone prices are declining.

With Christmas season coming up, the "sweatshops" will be operating around the clock, and the risks of further worker discontent and factory shutdowns are on the rise. As a longer term strategy, Apple and others must be considering alternate suppliers outside of China, which does not bode well for China's manufacturing sector.

High Yield corporate loans (sometimes also called "institutional", "syndicated", "leveraged", "par", or "bank" loans) continue to be in high demand. And it's not only hedge funds and CLOs (see post) who like this product. Retail investors are piling in as well. Institutional loan mutual funds' assets under management are close to record, as inflows stay high.

Loan funds AUM (source: LCD)

These are loans to sub-investment grade firms such as HCA, Harrah's Entertainment, Reynolds, Avaya, First Data, etc. What makes this product so attractive? Investors like it because the assets pay floating rate (LIBOR plus spread). That means if short-term rates begin to rise, the coupon payments will increase. If inflation picks up for example, most expect these assets to compensate them for the loss in real value (although the risk is that the dovish Fed keeps short-term rates low in spite of inflationary pressures). Also because these loans are senior secured, there is more protection (collateral) than is offered by HY bonds in case of default. And default rates have been relatively low recently.

HY Corporate Loan Default Rates (% per year)

A popular retail product that provides exposure to this asset class is a closed-end fund called Eaton Vance Senior Floating Rate Trust (EFR). The fund is up 21% year-to-date on a total return basis (including dividend).

12/31/2011 = 100

When a fixed income fund has such an outstanding return, it is always important to compare it to the representative index. The S&P/LSTA Loan Index year-to-date return is 8.09%. So how is it that EFR was over 20% with roughly the same type of assets? The outperformance here is not just about picking the right names as would be the case with equity funds. Just as mortgage REITs (discussed here), most of these loan funds run some leverage. The EFR fund prospectus clearly says: "Performance results reflect the effects of leverage resulting from the Fund's issuance of Auction Preferred Shares" (a form of debt). Which means that if the loan index is down, this fund would be down much more.

As spreads stay low and investors reach for yield, demand for leveraged product - even at the retail level - is going to become commonplace in fixed income.

Sunday, September 23, 2012

The Eurozone recession is having a somewhat unexpected effect on the periphery nations' current accounts. As was the case with Portugal (see this discussion), the Eurozone periphery has eliminated its trade deficit.

Source: CS

Domestic demand in these nations has collapsed, dramatically shrinking imports and improving the external balance. These nations just can't afford many of the goods they used to import. And as the periphery eliminated its trade deficit, the Eurozone as a whole went into a trade surplus.

Source: CS

This improvement to the area's current account balance was at the expense of a massive GDP reduction, negatively impacting global economic growth.

CS: - We think that sharp, crisis-induced, rise in the euro area’s current account balance –
worth around two percentage points of euro area GDP in the past nine months – has
generated a significant negative shock to the global economy.

This is one of the reasons the UK for example is struggling with a rising trade deficit (see this discussion) and a double-dip recession. Spain, Italy, Portugal, Ireland, etc. are no longer in a position to be buying British and other nations' products and services as they did in the past.

Back in early July we saw the post-EU-summit euphoria quickly fade as the new initiatives discussed at the meeting stalled at the implementation stage (see discussion). It certainly feels as if so much has happened since then. But has it? Other than Draghi's backstop to support short-term sovereign paper, what has really changed in terms of the union's structure and other summit initiatives? Here is the latest on some of these efforts.

1. Spain has not seen a cent of the €100bn bank bailout funds that were pledged by the Eurozone's leadership so far. The funds are surely coming, but it has been almost four months (see discussion). We are seeing the best of the EU's bureaucracy in action.

2. Pan-Eurozone bank supervision implementation has also stalled.

Reuters: - Euro zone finance ministers meeting in Cyprus last weekend failed to agree on the framework for banking union, with Germany and others concerned that deposit guarantees will put them on the hook for banks in Greece or Spain by using deposits in their local banks to fund rescues in other countries.

...
The European Commission unveiled sweeping plans for the ECB to supervise all euro zone banks last week as a first step toward a banking union, though Germany immediately raised objections that the proposals risked overstretching the ECB.

...
The euro zone risks disintegration unless governments can agree on a banking union underpinned by a universal deposit safety net, former European Central Bank policymaker Athanasios Orphanides said on Saturday.

The bickering is now at the Merkel - Hollande level. This development sent the euro lower by a percent last week after a strong rally.

Bloomberg: - Chancellor Angela Merkel and President Francois Hollande
underlined Franco-German disagreement over the weekend as they
clashed on a timetable to introduce joint oversight of the
region’s banking sector, with Merkel rebuffing Hollande’s appeal
to activate it “the earlier, the better.”

3. The ability to scale the ESM's buying power using leverage is also in question. Der Spiegel reported that the vehicle could be levered as high as €2trillion - the ultimate "bazooka". Not so fast, says Finland.

Reuters: - If the ESM gets approval to use the same leverage techniques as the EFSF, it would have a lending power of around 2 trillion euros without countries having to contribute any more capital to the fund.

But these leverage options have not been approved by all euro zone member states and Finland is especially reluctant to agree to them.

German Finance Minister Wolfgang Schaeuble supports the plan but Finland is preventing the Eurogroup from passing it quickly, the report said.

With the ECB's backstop in place, the ultimate size of the ESM doesn't really matter any more, but it points to a continuing discord in the Eurozone.

4. To add to the tensions, Der Spiegel also brought up the fact that a preliminary troika report shows a €20bn gap in Greece’s budget. This is setting the stage for another "debate" on whether the austerity requirements attached to the EU/IMF loans to Greece (and/or the loans themselves) should be restructured to give Greece more time. Today France said yes. It's not clear how the rest of the Eurozone leadership will respond tomorrow.

FT: - France has said Greece should be given more time to meet the terms of its international bailout, in the clearest call yet by a leading eurozone country for an easing of the stringent conditions attached to the €174bn rescue package.
Jean-Marc Ayrault, the prime minister, taking a clear swipe at those in Germany insisting on a hard line against Athens, warned that a Greek exit from the eurozone would be “unmanageable” and could be “the beginning of the end of the European project”

5. In the mean time frustrations grow over Italy's and particularly Spain's reluctance to ask for the official ECB-led bailout. Business leaders understand that locking in a revolving credit line, while the going is good, is a prudent strategy (rather than begging for it under duress). Spain's leadership apparently does not (see discussion).

The Spanish government said earlier this week that it is studying the conditions attached to seeking a bailout.

Spain has already asked for a loan for up to 100 billion euros ($129.5 billion) to recapitalize its banks, but as its finances deteriorated over the summer, pressure mounted for the country to seek help to lower its sky-high borrowing costs.

Mr. Gonzalez, who was speaking at an event in Madrid, said a request for a credit line by Spain would activate the European Central Bank's sovereign bond purchasing program, known as Outright Monetary Transactions, which would push down borrowing costs.

A great deal has been accomplished in the Eurozone in terms of easing the financial strain (see discussion) since the summit back in June. But as these recent developments show, this progress has been mostly due to the ECB providing an unlimited backstop to the periphery governments. Without this (what is turning out to be long-term) "bridge" financing, the actual progress on restructuring the Eurozone's financial and fiscal union/institutions has been painfully slow.